Middle East Turmoil Not What It Used To Be In Oil Markets

American crude supply offers a plentiful alternative

Photo by Zbynek Burival on Unsplash

Written on September 18, 2019

The attack on Saudi oil facilities over this past weekend knocked out more than half the kingdom’s current daily production of 9.8 million barrels, amounting to about 5% of global supply.  To be sure, a major disruption that shattered investor complacency and exposed the vulnerability of an important global energy source.  On Monday, the price of crude oil for nearby delivery shot up by almost 20%, the largest one-day move on record.  A consensus quickly formed around the possibility of future similar attacks, necessitating increased risk premium and ushering in an era of permanently higher crude prices.

The incident also raised broader concerns.  Investors are naturally wary of oil price shocks and for good reason.  According to Steven Kopits of Princeton Energy Advisors, many of the recessions since 1945 have been triggered by Middle East wars and oil politics.  The 1956-57 Suez Crisis, the 1973 Yom Kippur War and resulting oil embargo, the 1979-83 Iran-Iraq war, the first Gulf War in 1991 and the 2011 Arab Spring all produced negative economic fallout in the US and other advanced economies. See https://bit.ly/2kSJJ4j.

But what looked to be a potentially game-changing event in the markets on Monday morning was already fading in the rear-view mirror by Tuesday afternoon.  Prices in the futures market had largely retreated to near levels seen before the attack after Saudi assurances that production capabilities would be fully restored in the next few weeks, sooner than initially expected. See https://fxn.ws/2knw84S .  However, that is only part of the story. 

Global crude supplies remain plentiful, especially as expanding shale production in the U.S. provides a reliable alternative to Middle Eastern oil.  Already the world’s leading producer, domestic American supply is expected to increase by another 1 million barrels per day over the next year to 13.3 million barrels, an almost 50% jump from this time in 2016. Bloomberg reports that more than ten export terminal projects along the Gulf of Mexico coast are in the works to handle the expected surge, notably from the oil-rich Permian Basin. See https://bloom.bg/2kDMyX7.  Ironically, according to Donald Luskin at Trend Macrolytics, OPEC was already looking to cut production among its member countries to offset the increase in American crude and prevent an outright glut in the marketplace. See https://on.wsj.com/2kTfL0f.  He notes that the last thing the Saudis need in the lead-up to the Aramco IPO is a collapse in prices or a war with Iran.

Another limiting factor to any potential oil shock is the diminishing impact of the price of crude on the economy.  In a Barron’s interview, Barry Banister, head of institutional equity strategy at Stifel Nicolaus figures that the $2 trillion spent annually worldwide on oil at current prices amounts to only about 2.6% of the $85 trillion global economy, far less than the 6.5% of the early 1980s.  He calculates that even if crude were to average $100/barrel (from $63 currently) that figure would rise to only around 4%, still well below historical standards https://bit.ly/2knG7qS.

The lesson of the past several days, as calm has quickly returned to both energy and equity markets, is that Middle Eastern oil matters but not nearly as much as it used to in the past.

WTI Crude for September 2020 delivery. What crisis?

Loonie Set To Get Its Wings Clipped

Canadian dollar vulnerable to drop in energy prices

Photo by Michelle Spollen on Unsplash

July, 21, 2019

Energy is by far Canada’s largest export and production accounts for close to 10% of the country’s annual GDP. Subsequently, the Canadian dollar, colloquially known as the Loonie after the bird featured on the back of the dollar coin, is heavily influenced by the state of play in that sector and rarely strays too far from the prevailing trend in commodities prices, especially oil.

So far in 2019, the CAD has ridden a rising tide in stocks and commodities as the major central banks, led by the Fed, try to reflate the markets and breathe life into an aging economic cycle.

The promise of plentiful liquidity has been generally successful in driving financial markets higher, but we have doubts that this strategy will produce a meaningful boost to actual growth. One reason for that skepticism is derived from the distinct underperformance of the commodities complex this year (see chart below.) As a macroeconomic benchmark, commodities appear to be far less optimistic on the future than the message coming from the stock market. Like any divergence between normally-correlated markets, it could mean nothing or it could be an important message. Time will tell.

Oil, in particular, has had a very bad week when perhaps it shouldn’t have, given the tension with Iran in the Strait of Hormuz where 20% of the world’s petroleum supply passes. See https://bit.ly/2Y5BJyI. Prices in the futures market are down more than 9% and the energy sector as a whole looks vulnerable to further pressure. It’s tempting to sell commodity-sensitive currencies on the bet that they will follow suit.

Shorting the Canadian dollar represents an attractive risk/reward proposition. Not only is it still within 0.5% of its highs on the year (vs USD) but unlike most of its peer group of commodity currencies the speculative community is long and leaning the other way.

Calling turns in any market is tricky. We like owning USD/CAD here as long as it holds 1.3000, a risk of less than 1%. We think it’s a good trade but if we are wrong it won’t cost a lot to find out.

If you would like to discuss this or any other trading strategies please feel free to contact us at atradersperspective@gmail.com.

As a forward-looking indicator on the economy, commodities (blue) are decidedly less optimistic than stocks (orange).
The Canadian dollar (orange) and XOP, the oil and gas exploration ETF (blue). Both are vulnerable.